ERM II and Banking Union Membership – The New Challenges for Bulgarian Banks

ERM II and Banking Union Membership – The New Challenges for Bulgarian Banks

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Оn 10 July, 2020, just over two years after Bulgaria formally announced its intention to join the Exchange Rate Mechanism II (ERM II) and the Banking Union, the European Central Bank (ECB) and the Bulgarian National Bank (BNB) announced two very important decisions:

  1. The inclusion of the Bulgarian lev in the ERM II, making Bulgaria, together with Denmark and Croatia, one of the three ERM II participants that is not part of the Eurozone (the ERM II Agreement); and
  2. The establishment of close cooperation between the ECB and the BNB, triggering the process of Bulgaria’s accession to the Banking Union (i.e. Bulgaria’s accession to the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM)) (the Cooperation Decision).

Following the introduction of various COVID-19 related measures and most notably after the publication of the EC’s 2020 Convergence Report many had speculated that the two decisions would be postponed. However, not meeting in full the convergence criteria for the euro area does not preclude Bulgaria from joining the ERM II.

The ERM II Agreement set the central rate of the Bulgarian lev to BGN 1.95583  for 1 Euro. This is a preservation of the pre-existing exchange rate as defined in Bulgarian law. The new requirement, which stems from EMR II membership itself is that this central rate must be maintained within the standard ERM II fluctuation band of plus or minus 15 percent. 

Maintaining the central rate within the standard fluctuation band should not be a problem, as the ERM II Agreement also notes that Bulgaria joins the exchange rate mechanism with its preexisting currency board arrangement in place (dating back to 1997 and at the time providing for a peg to the German mark), without making any changes to its framework. Furthermore, the ECB and the BNB announced the so-called “compulsory intervention rates” – i.e. the agreed fluctuation limits of the central rate (upper and lower rate), for the purposes of which the so-called automatic intervention would be triggered. Thus, when the upper rate of BGN 2.24920 for 1 euro or the lower rate of 1.66246 BGN for 1 euro is reached, the ECB and the BNB can resort to the “automatic intervention”, a supportive instrument used for the purposes of stabilizing exchange rates. For example, a “very short-term financial facility” can be established, under which the BNB and the ECB mutually create “financial facilities” for each other for an initial period of maximum three months, where each of the central banks spot sales or purchases the corresponding currency.

The decision to include Bulgaria in ERM II is based, inter alia, on the successful fulfillment of the commitments made by the Bulgarian authorities in relation to the ERM II and the Banking Union, which were communicated as part of the submission of the formal notification of intention for joining them. Nevertheless, the ERM II Agreement is accompanied by a number of other post-entry commitments made by Bulgaria with a view to preserving the economic and financial stability and to achieve the aforementioned economic convergence. These post-entry commitments pertain to a number of measures in the area of: (1) the non-banking financial sector and the strengthening of their regulatory and supervisory regimes; (2) the state-owned enterprises and the effective implementation of the Public Enterprises Act; (3) the insolvency framework, providing for a number of legal and organizational changes; and (4) the strengthening of the anti-money laundering framework, by increasing the powers of the supervisors and introducing a number of other measures related to the identification and management of money laundering risks.

It remains to be seen what the specific legislative changes will be, but the Bulgarian financial sector will certainly undergo a number of changes flowing from the applicable requirements in the field of the aforementioned four areas.

At the same time, the banking sector will also undergo a number of other changes in the areas of banking supervision and the recovery and resolution of credit institutions. 

On one hand, with the entry of the Cooperation Decision into force, the anticipated date of which is October 1, 2020, Bulgaria will become part of the Banking Union and a member of the SSM. Thus, the amendments to the Bulgarian Credit Institutions Act (CIA) will also come into force, according to which the BNB should comply with all of ECB’s guidelines and requests and take the necessary measures to implement the ECB’s legal acts. In this context, the powers of the BNB to impose administrative sanctions for violations of both the CIA and a number of directly applicable EU acts (including their implementing acts) will also increase.

This means that, starting from October 1, 2020, and fallowing the completion of the significance assessment process, the ECB will become responsible for the direct supervision of Bulgaria’s significant credit institutions. To date, none of the banks in Bulgaria is considered to meet the materiality criteria as set out in the SSM Regulation (Regulation 1024/2013) and the SSM Framework Regulation (Regulation 468/2014), namely:

  1. Size: the total value of its assets exceeds €30 billion; or
  2. Economic importance: for the specific country (e.g. possibly the fourth largest bank (see below) or the EU economy as a whole; or
  3. Cross-border activities: the total value of its assets exceeds €5 billion and the ratio of its cross-border assets/liabilities in more than one other participating Member State to its total assets/liabilities is above 20%; or
  4. Direct public financial assistance: it has requested or received funding from the European Stability Mechanism or the European Financial Stability Facility

The significance status is reviewed annually and it affects not only whether a bank will come under the ECB’s direct supervision but also the amount of the annual supervisory fee, the introduction of which will also be a significant change for Bulgarian banks. Irrespective of whether the significance status criteria is met, however, the ECB also assumes the direct supervision of the three most significant banks in each of the member states, that is either an Eurozone Member State or a member state with which the ECB has established close cooperation.

Thus, following the completion of the initial significance assessment, up to three of the Bulgarian banks will fall under the direct supervision of the ECB. These banks will also have to take into account a number of new developments in the ongoing supervisory procedures, such as the on-site and off-site inspections that are carried out by the ECB. It is expected that at least two of these three banks are part of banking groups that have long been under the supervision of the ECB.

The new supervisory procedures will also affect all other banks, as the ECB is also responsible for the oversight of less significant credit institutions (i.e. those remaining under the direct supervision of the BNB), as well as for all common procedures for all supervised entities. For example, the SSM Framework Regulation stipulates that the BNB should also be given the powers to conduct inspections (including those involving ECB staff) and to issue reports with findings that are binding on banks (including those that potentially affect capital requirements).

On the other hand, the Banking Union membership also means that from 1 October, 2020, Bulgaria will join the SRM. Therefore, banks that will come under the direct supervision of the ECB will also be subject to the direct supervision of the Single Resolution Board (SRB). In its Baking Union resolution authority role, the SRB decides on the resolution of all banks under its direct supervision, as well as all cross-border banking groups (i.e. even if a Bulgarian bank is not subject to the direct supervision of the SRB (e.g. the fourth or subsequent largest bank), it will be subject to indirect supervision by the SRB, if it is part of an EU banking group, where the group is subject to direct SRB supervision). 

Similar to ECB’s role in the SSM, the SRB participates, as an observer, in the restructuring of the less significant institutions, which remain under the direct supervision of the BNB (in its role as national resolution authority). In this context, it is safe to assume that a number of other legal changes will follow, given that the SRB is also responsible for establishing standard rules and procedures for the resolution of entities, some of which are yet to be introduced by the BNB.

Last but not least, the SRM includes the Single Restructuring Fund (SRF), which should be used for resolving insolvent banks, with the aim of minimizing costs for taxpayers and the real economy. The SRF is still in the process of being set-up (the transition period is planned to end in 2023), and its aggregate amount is estimated at about 55 billion euros or at least 1% of the amount of guaranteed deposits of all licensed credit institutions within the Banking Union. 

This means in practice that certain Bulgarian banks (and all investment firms and financial institutions covered by the consolidated supervision of the parent undertaking carried out by the ECB) will have to pay contributions to the SRF. The amount of individual contributions is calculated in proportion to the amount of the bank’s liabilities in relation to the total liabilities of all licensed credit institutions in the Banking Union, excluding equity and guaranteed deposits. The contributions are then risk-weighted, but even if adjusted there is no hypothesis in which the contribution is equal to zero.

In a recapitulation, the ERM II Agreement and the Banking Union membership do mark a new page in Bulgaria’s EU integration, which in turn would lead to a number of legal changes that will affect the entire financial sector and will require extensive revisions of the procedures, policies and systems of both the banking and non-banking financial sectors.

By Kristina Dimitrova, Associate, and Nikolay Bebov, Managing Partner, Tsvetkova Bebov Komarevski